Efficiency versus stability

Posted
on August 29, 2011, 5:01 pm

The graphic accompaning physicist Mark Buchanan’s recent opinion piece at Bloomberg is one of the best short summaries I’ve seen so far of the challenge facing our efforts to restructure world financial markets:

Source: Serifcan Ozcan, Bloomberg.

The photograph is also an excellent visual representation of Buchanan’s main point:

Efficiency is generally a good thing. We don’t want our car engines to waste fuel through internal friction or the heat from our furnaces to slip out the window.

Yet there are limits to efficiency’s virtue. It’s no good having a lightweight super-efficient engine that melts when it heats up, or clatters into pieces on a bumpy road. For any technology, too much efficiency can compromise properties that are required for stability. And stability matters, too.

The same is true in the world of finance.

In the run-up to the current crisis, we ran our financial markets right up to the brim. Stability, however, demands that we leave some room at the top. Buchanan uses a drier metaphor that makes the same point: “Ensuring market safety may require some throwing of sand into the machinery, giving up a little efficiency to gain greater stability.”

The only part of Buchanan’s piece that misses the mark is his musings on a financial transactions tax (FTT). An FTT would impose a very small tax –something like one-quarter of one percent– on the purchases of stocks (and an even smaller tax on derivatives). Economists Bob Pollin and Dean Baker estimate that such a tax could raise considerable amounts of revenue (pdf), while reducing the volume of super-short-term speculative purchases of securities.

This sounds exactly like the kind of grit in the gears that Buchanan is calling for, but he is somewhat dismissive of the proposal: “The sand might, for example, take the form of a tiny tax on speculative trading. The trouble is, such a tax might turn out to reduce efficiency without actually improving stability, as some economists have argued. We don’t yet know.”

Fair enough. We don’t yet know definitively that an FTT would produce just the right amount of stability at the lowest cost in efficiency. But, the idea already has substantial support among economists (pdf) who have looked at the issue, and the risks seem small. Dean Baker estimates that an FTT in the range currently being discussed would raise the average transaction cost back to what it was in the mid-1980s –hardly the dark ages of finance. An FTT would raise revenue, help to shrink our bloated financial sector, and for now looks to be the best option on the table for putting the sand Buchanan wants in the financial machinery.